What is Basic Earnings Per Share?
Basic earnings per share (EPS) tells investors how much of a firm’s net income was allotted to each share of common stock. It is reported in a company’s income statement and is incredibly informative for businesses with only common stock in their capital structures.
Understanding Basic Earnings Per Share
One of the first performance measures to check when analyzing a company’s financial health is its ability to turn a profit. Earnings per share (EPS) is the industry standard that investors rely on to see how well a company has done.
Basic earnings per share is a rough measurement of a company’s profit amount that can be allocated to one share of its common stock. Businesses with simple capital structures, where only common stock has been issued, need only release this ratio to reveal their profitability. Basic earnings per share do not factor in the dilutive effects of convertible securities.
Basic EPS = (net income minus preferred dividends) ÷ weighted average of common shares outstanding during the period.
Net income can be further broken down into ‘continuing operations’ P&L and ‘total P&L’; preferred dividends should be removed as this income is unavailable to common stockholders.
If a company has a complex capital structure where the need to issue additional shares might arise, then diluted EPS is considered a more precise metric than fundamental EPS. Diluted EPS considers all of the outstanding dilutive securities that could be exercised (such as stock options and convertible preferred stock) and shows how such an action would affect earnings per share.
Companies with a complex capital structure must report both essential EPS and diluted EPS to provide a more accurate picture of their earnings. The main difference between essential EPS and diluted EPS is that the latter factors in the assumption that all convertible securities will be exercised. As such, essential EPS will always be higher than the two since the denominator will always be more significant for the diluted EPS calculation.
Basic Earnings Per Share Example
A company reports a net income of $100 million after expenses and taxes. The company issues preferred dividends to its stockholders of $23 million, leaving earnings available to common shareholders of $77 million. The company had 100 million common shares outstanding at the beginning of the year and issued 20 million new ordinary shares in the year’s second half. As a result, the weighted average number of common shares outstanding is 110 million: 100 million shares for the first half of the year and 120 million shares for the second half of the year (100 x 0.5) + (120 x 0.5) = 110. Dividing the earnings available to common shareholders of $77 million by the weighted average number of common shares outstanding of 110 million gives an essential EPS of $0.70.
Impact of Basic Earnings Per Share
Stocks trade on multiples of earnings per share, so a rise in EPS can cause a stock’s price to appreciate in line with the company’s increasing earnings on a per-share basis.
Increasing EPS, however, does not mean the company is generating greater earnings on a gross basis. Companies can repurchase shares, decrease their share count, and spread net income-less preferred dividends over fewer common shares. EPS could increase even if absolute earnings decrease with a falling daily share count.
Another consideration for Essentials is its deviation from diluted EPS. If the two EPS measures are increasingly different, it may show that there is a high potential for current common shareholders to be diluted in the future.
Conclusion
- Basic earnings per share (EPS) tells investors how much of a firm’s net income was allotted to each share of common stock.
- Businesses with simple capital structures, where only common stock has been issued, need only release this ratio to reveal their profitability.
- Companies with a complex capital structure must report both essential EPS and diluted EPS to provide a more accurate picture of their earnings.
